Definition
A capital loss is realized when an investor sells a capital asset for a price below its original purchase price. Capital losses can be used to offset capital gains on tax returns and, within limits, can also offset ordinary income.
Detailed Explanation
Capital losses are significant for tax purposes because they can be used to reduce the taxable income. The IRS allows taxpayers to use capital losses to offset capital gains. If capital losses exceed capital gains, up to $3,000 of the excess loss can be deducted from other income types like wages, interest, or dividends. If the total loss exceeds this threshold, the remaining amount can be carried forward to future tax years.
Calculation:
\[ \text{Capital Loss} = \text{Purchase Price} - \text{Selling Price} \]
Example
Collins, an investor, purchases land for $100,000. Two years later, she sells it for $80,000. The $20,000 difference ($100,000 - $80,000) is a capital loss since the land is a capital asset.
Frequently Asked Questions (FAQs)
What is a capital asset?
A capital asset includes property or investments such as stocks, bonds, real estate, and personal property that is levied in value. Common examples include property owned for investment purposes like land, buildings, machinery, etc.
Can capital losses be carried forward?
Yes, capital losses that exceed the yearly limits can be carried forward to future years until they are fully utilized.
Is there a limit to the capital loss deduction?
For individuals, the IRS allows a maximum deduction of $3,000 per year ($1,500 if married and filing separately) to be used to offset other income types.
Can both short-term and long-term capital losses be deducted?
Yes, both short-term (held for less than a year) and long-term (held for more than a year) capital losses can be deducted. However, short-term losses must first be used to offset short-term gains and long-term losses to offset long-term gains.
What is the capital loss carryover rule?
Under the IRS rules, if your capital losses exceed your capital gains, you can carry over the unused part to following years, indefinitely, until the loss is fully deducted.
How does the IRS treat losses from the sale of personal property?
The IRS generally does not allow deductions for losses from the sale of personal-use property such as furniture, vehicles, and appliances.
Related Terms
Capital Asset
A capital asset is any significant piece of property owned for its role in contributing to a business’s ability to generate profit, like land, machinery, buildings, and inventory.
Capital Gain
A capital gain is the profit that results when a capital asset, such as an investment or real estate, is sold for a higher price than the purchase price.
Ordinary Income
Ordinary income refers to earnings received from providing services, such as wages, salaries, commissions, and interest income.
Tax Deduction
A tax deduction reduces the amount of income that is subject to tax. Deductions can include various expenses, like property costs, interest, and some educational expenses.
IRS (Internal Revenue Service)
The IRS (Internal Revenue Service) is the U.S. government agency responsible for tax collection and tax law enforcement.
Short-term Loss
Short-term loss occurs from the sale of an asset held for less than a year, resulting in a lesser tax advantage than long-term losses.
Long-term Loss
Long-term loss occurs from the sale of an asset held for more than a year, and it might have a more favorable tax treatment if it offsets long-term capital gains.
Online Resources
- IRS Publication 550 – Comprehensive details on Investment Income and Expenses.
- Investopedia’s Guide on Capital Losses
- The Motley Fool on Capital Gains and Losses
References
- IRS Publication 544, Sales and Other Dispositions of Assets.
- IRS Publication 551, Basis of Assets.
- Internal Revenue Code, Section 1211 (Limitations on Capital Losses).
Suggested Books for Further Studies
- “Tax-Free Wealth” by Tom Wheelwright – Strategies for optimizing tax advantages, including managing capital losses efficiently.
- “Investing 101: From Stocks and Bonds to ETFs and IPOs, an Essential Primer on Building a Profitable Portfolio” by Michele Cagan – Basics of investing, including the intricacies of dealing with gains and losses.
- “Common Sense on Mutual Funds” by John C. Bogle – Detailed explanations on investing and tips to manage capital gains and losses.
